On a Monday morning, a district hospital asks for funds to repair its oxygen plant. The State health department scrapes its budget and waits for a release from the Union. This is how a cash pinch travels from Delhi to a ward bed. Restoring fiscal space for the States is not a theory question; it is about whether schools, hospitals, buses, and canals work on time.

How We Reached Here — Three Big Squeezes

1. Goods and Services Tax changed the tax map: With GST, many buoyant State taxes (octroi, entry tax, cesses) were merged. The five-year GST compensation cushioned losses, but now it has ended. The Compensation Cess continues only to repay past borrowings, not to support State revenues.
2. A thinner divisible pool: The Finance Commission gives States 41% of the divisible pool of Union taxes. However, rising cesses and surcharges are outside this pool, shrinking predictable State income.
3. Tight borrowing rules: Under Article 293 and State FRBM laws, States face ceilings around 3% of GSDP. New conditionalities and off-budget adjustments have further reduced fiscal headroom, even for productive works.

Why the Squeeze Hurts Development

• Most core services—health, school education, water supply, policing—are delivered by States.
• Centrally Sponsored Schemes demand matching shares and compliance costs, forcing States to delay vital maintenance.
• Uncertain releases lead to end-year spending rushes, weakening accountability and quality.

What to Fix — A Practical, India-Style Plan

A. Make Devolution Predictable and Fair

• Cap or sunset cesses and surcharges; move revenues back into the divisible pool.
• Publish a quarterly transfer calendar for predictability.
• Ask the 16th Finance Commission to reward service outcomes, not just income levels.

B. GST Federal Compact 2.0

• Revisit compensation architecture with trigger-based, time-bound support for tax-base shocks.
• Speed up GST refund settlements and audits.
• Simplify rate slabs and prune leak-prone exemptions.

C. Smarter Borrowing for Growth

• Permit higher borrowing limits for vetted capital projects with economic returns (e.g., water, transport, irrigation).
• Create a Counter-Cyclical State Facility for downturn support.
• Standardise off-budget borrowing rules and promote transparent instruments like InvITs.

D. Repair the Scheme Maze

• Rationalise and merge overlapping Centrally Sponsored Schemes.
• Link Union grants to outcomes and audits, not only inputs.
• Shift more funds to untied maintenance transfers.

E. Strengthen the Bottom Rung

• Activate State Finance Commissions with binding implementation plans.
• Allow cities to escrow a share of transfers to issue credible municipal bonds.
• Ring-fence user charges for O&M of civic assets.

F. Publish and Persuade

• Create a public dashboard showing devolution trends, cesses, borrowing limits, and payment lags.
• Encourage States to publish quarterly outcome notes and citizen budgets.

Quick Map — Problem to Fix

Important Terms Explained

• Divisible pool: Portion of Union taxes shared with States under Article 270.
• Cess and surcharge: Union levies not shared with States.
• GST compensation: Time-bound support for revenue loss post-GST; now discontinued.
• Article 293: States’ borrowing requires Union consent if indebted to the Centre.
• Untied transfer: Grant where States decide usage freely.
• Counter-cyclical policy: Fiscal support in bad times, withdrawn in good times.

What the Evidence Suggests

States maintaining higher capital-to-revenue expenditure ratios saw faster recovery in jobs and incomes post-pandemic. Stable, untied funds lead to better maintenance and long-term welfare gains than one-time capital projects.

Exam Hook

Base your Mains answers on three levers: (1) enlarge and stabilise the divisible pool, (2) a GST Compact 2.0, and (3) growth-friendly borrowing plus scheme rationalisation. Mention Articles 270, 293, and the roles of Finance Commission and State Finance Commissions.

Key Takeaways

• Fiscal stress at State level arises from shrinking shareable revenues, the end of GST compensation, and limited borrowing space.
• Solutions lie within India’s federal system—cap cesses, stabilise transfers, allow smart borrowing, rationalise schemes, and empower local bodies.
• Restoring State fiscal space is crucial for improving education, healthcare, and urban services.

UPSC Mains Question

“After the Goods and Services Tax, India must now fix the federal money pipes.” Discuss measures to restore fiscal space for States—covering devolution and cesses, GST compensation design, borrowing under Article 293, rationalisation of Centrally Sponsored Schemes, and the role of State Finance Commissions.

UPSC Prelims Question

1. Cesses and surcharges collected by the Union are not part of the divisible pool shared with States.
2. The Fourteenth Finance Commission reduced the States’ share in the divisible pool from 42% to 41%.
3. A State indebted to the Union cannot raise loans without Union consent under Article 293.

Correct Answer: 1 and 3 only. (The reduction to 41% came under the Fifteenth Finance Commission after J&K reorganisation.)

One-Line Wrap

Put trust back in federal finance — share fairly, borrow smartly, and let States spend where citizens meet the State: in schools, clinics, and streets